The IRS has changed how business Assets, Repairs, and Supplies will be handled beginning January 1, 2014. There are important steps to take!! Please schedule an appointment with us ASAP so we and help you comply with the new changes.
Over the past number of years, the Internal Revenue Service has audited numerous clients on the issue of repairs and maintenance. There have been a few of these audits that were taken to Tax Court, and in most cases the IRS has lost. Most notably was a case where a delivery company was expensing the cost of a replacement airplane engine. Apparently, the IRS is tired of losing these cases. On September 19, 2013, the IRS released final regulations providing guidance on acquisition, repair and improvements of tangible property, materials, and supplies. This monstrosity is commonly known as the “Repair Regs”.
There has not been much, if any, discussion of this issue in the media. This is probably because the issue is so complex that very few people actually understand it, least of all the media, or even the IRS. Common opinion among tax professionals is that these Regs will cause more harm to the small business community than the Affordable Care Act (Obamacare).
Regardless of my personal feelings on this issue, it is important that you understand it. Thus, I will do my best to explain it in this letter. Every single transaction that falls into the scope of these Regs must be examined by someone in your business. It could be you, one of your staff, or even me. It will be time consuming. It will cause extra paperwork. With practice, I hope the process will become smoother. And, yes, I will bill extra if I am the one assigned to ensure that your business is complying with these Regs. Therefore, I urge you to review this letter thoroughly.
FORMER STANDARD PRACTICE
The issue at hand is whether a particular purchase is expensed outright, providing a current year tax deduction, or capitalized as an asset and depreciated over a certain number of years. In general, a $100 deduction this year is much better than a $20 deduction, followed by a $32 deduction next year, a $19.20 deduction the year after that, etc. etc. until the entire cost is finally deducted. Some assets have a 5-year useful life (computers and vehicles), a 7-year life (equipment and furniture), or even a 39-year life (a commercial building).
With regards to materials and supplies, a “rule of thumb” that many professionals used (including myself) was that if a particular item cost less than $500, it was expensed outright. Yes, that $450 computer may last 5 years, but under the rule of thumb it would be written off entirely in the first year. Some larger businesses would use a $1,000 rule of thumb, or even $5,000. As long as the rule was applied consistently, the issue would typically survive an audit by the IRS.
For repairs, there was also a rule of thumb. If the repair extended the useful life of the asset, or altered the asset in such a manner that it changed its basic function, then the cost of the repair was capitalized and depreciated. Otherwise, it was expensed. Replaced a flat tire? Expensed. Painted a room? Expensed. A complete engine overhaul of an 18-wheeler that allows it to travel another 300,000 miles? New asset. Retooled a piece of manufacturing equipment to work with a different type of product? New asset.
The other rule was that if a particular purchase or repair was expected to last less than one year, it was expensed.
The new Regs do away with these rules of thumb, replacing them with an instruction manual (222 pages worth). Keep in mind that the Regs do not eliminate your tax deduction. A business expense will still be a business expense. The Regs provide guidance on when and how you can claim that expense.
UNIT OF PROPERTY
The Regs reference a new item … the “Unit of Property” (UOP). Whether an item can be expensed or should be capitalized is based in part on whether it is a UOP or part of a UOP. All of the components that are functionally interdependent make up a single UOP. Yes, I really did just type that. Two or more components are functionally interdependent if you must place each of them in service at the same time for them to perform their intended functions. For example, a computer and printer are considered two units of property because either could have been placed in service without the other. You can swap out either one without affecting the other. On the other hand, a car and its engine are considered one UOP. One part cannot function without the other. The distinction is important.
NEW RULE: MATERIALS AND SUPPLIES
The rule of thumb for this still exists in some part, but the dollar limit is now only $200. “Materials and supplies” are defined as tangible property that is used or consumed in the business operations. Office supplies are a good example. That $10 trash can? Expense it. $50 stapler? Expense that too.
The new Regs indicate that this particular issue is a “per item, per invoice” issue. If you have an invoice from Office Depot that totals $600, you will need to look at every single item on that invoice. If any one particular item is over $200, you must capitalize that item and depreciate it. All items under $200 can be expensed. If the total invoice is under $200, expense it.
How about a $199 fax machine, and you also pay the vendor $75 to install it and train you on its operation? That is a total of $274. Since it is over $200, it must be capitalized correct? Under the “per item” stipulation, each item on the invoice is less than $200, therefore it can all be expensed. However, if the vendor billed you $274 outright, with no detail on the invoice, then you would capitalize the fax machine and depreciate it.
Certain categories of materials and supplies are also allowed to be expensed outright. “Consumption-type” items can be expensed, such as fuel, water, and lubricants, as long as the items are consumed within 12 months. Any Unit of Property with a useful life of less than 12 months is also expensed. Items purchased for resale (inventory) do not follow these new rules.
NEW RULE: EQUIPMENT REPAIRS
This category includes repairs to any and all assets owned by the business, with the exception of Building Repairs. There is an election to apply a rule of thumb to these repairs, which we will make when we file your tax return. The election must be made each year. The election allows you to use a $500 expense rule for equipment repairs.
Again the “per item, per invoice” rule applies, but this time with a $500 limit. Replacing all four tires on a vehicle for $400? Expense. Replacing all four tires on the company van for $600? Well that depends on the invoice. If it says “Replace tires, $600” you have a new asset to depreciate. If it says “Replace four tires @ $150 each”, you may expense it.
There is also what is called the “Routine Maintenance Safe Harbor” rule. Under this rule, an amount paid for routine maintenance performed on a UOP – other than a building – is deemed NOT to improve that UOP. This rule applies only if you expect to perform the routine maintenance more than once during that asset’s class life, the maintenance keeps the property in an ordinarily efficient operating condition, and the need for the maintenance results from your own use of the property. Thus, the tires on the company van would more than likely be expensed as routine maintenance, regardless of actual cost, because they will probably be replaced more than once during the van’s 5-year class life. If the new tires tripled the van’s gas mileage or adapted the van for off-road use, you would have a new asset to capitalize and depreciate. Likewise, if you bought the van used, and needed to immediately replace the tires, the cost of the replacement would become part of the asset. It was not your own use that required the tires to be replaced.
NEW RULE: BUILDING REPAIRS
This part of the new Regs really comes close to the realm of insanity. There are a couple of “safe harbor” provisions here as well. One such safe harbor is the Routine Maintenance rule above. The Regs also provide a “10-year” class life rule when it comes to such routine maintenance. Thus, if a maintenance project (such as painting) is expected to be performed at least once every 10 years, then that project will be deductible as a repair expense.
The other safe harbor rule for Building Repairs covers everything else. Can you use these “simplified” rules? First question – is your annual revenue less than $10 million? If not, you cannot use this safe harbor. If so, next question – is the cost basis of your building less than $1 million? If not, you cannot use this safe harbor. If so, keep reading. If you are in a situation where you cannot use the safe harbor, we need to have a meeting.
Applying this safe harbor rule is pretty straightforward. At the end of the year we will add up all of your building repairs that fail the “routine maintenance” test. If the total repairs are below the lesser of a) $10,000, or b) 2% of the cost of the building, then we expense all such repairs. If the total amount of repairs exceeds that limit, the total amount is capitalized and depreciated over the useful life of the building. The useful life of a commercial building is 39 years. The life of a residential building (for rental purposes) is 27.5 years.
Each year your repair costs exceed the dollar limitation, the total amount of those repairs will be capitalized, and will become part of the cost basis of your building. Eventually, the cost basis will exceed $1 million, and you will be forced out of the safe harbor.
WHAT YOU NEED TO DO
If you are currently keeping your own accounting records (using Quickbooks or similar), then you may need to add a handful of accounts to the Chart. You should already have accounts such as “Office expense” and “Supplies”. Keep these accounts and continue to use them, but ONLY for materials and supplies that qualify for expensing ($200 or less). You should also have an account to use for major equipment purchases that are depreciated. Use this account for any materials and supplies that fail the current expense rules. If you do not currently have these accounts, be sure to set them up.
For repairs, you should already have a “Repairs and maintenance” account. You should split this account into “Repairs – equipment”, “Repairs – building”, and “Repairs – capitalize”. The first two accounts should be used for repairs that qualify for expensing (less than $500, or routine maintenance). The other account should be used for expenditures that fail the expensing rules. We will review these expenditures together as part of our normal end of the year activity, and depreciate them accordingly.
If I am keeping your accounting records on a monthly or quarterly basis, then I will need more information from you. Any time you have an expenditure in the materials, supplies, or repairs categories, I will need to know how it needs to be classified: less than $200 expense, new equipment asset, less than $500 equipment repair, building repair, capitalized repair.
These new Regs apply to the 2014 year and thereafter, so there is no real need to go back through your 2013 accounting records and classify everything. However, the IRS has indicated that technically these Regs apply retroactively to the dawn of time. If you are audited on this issue, they may go back until the day you purchased your building and refigure everything that occurred in each subsequent year. By law, they can only adjust the past three years in normal circumstances. However, if you still own a building that you originally bought 20 years ago, and had significant repairs each year, then the IRS may reclassify all those repairs as a cost of the building, push the total cost over $1 million, and all of a sudden you cannot use the safe harbor rule for building repairs. The word “ludicrous” has come up in seminars.
I’ve mentioned that these Regs will cause harm to the small business community. I say that because the limitations explained above only apply to businesses that do not have audited financial statements. Many businesses are required to have annual audited financial statements, primarily publicly traded corporations. Those businesses with annual audited financial statements can set their own capitalization policy with regards to materials and supplies. Instead of a $200 limit, they can set it at $500, or even $5,000, or even $50,000. For repairs, instead of a $500 limit, they automatically have a $5,000 limit. These companies have the means and the staffing already in place to be able to apply these new Regs to their businesses, and yet they do not have the requirement. The small business owner, who does not have the means nor the staff nor the time, is required to comply.
There is one more thing you can do, and that is to write your Congressperson. These are Regulations, which means they were created by the IRS, not by Congress. The general opinion among professionals is that they were written by individuals with exactly ZERO practical experience when it comes to running a business. There have been attempts by professionals to inform Congress of the ridiculous nature of these Regs, but we need the small business owner to also inform them.
At some point, these Regs will be challenged in Tax Court. Until then, we will do the best that we can do with what we have. Study what I have written, think about it as the year progresses, and by all means call me if you have questions.